Transfer Pricing

Economic Consulting
Introduction to Transfer Pricing Principles,

Methods and Recent Developments
Sébastien Gonnet
Gonnet, NERA Economic Consulting
Hong-Kong, The Hong Kong Bankers Club, 28th September 2011
www.nera.com
Objectives of the Presentation
Provide an overview of the principles governing transfer pricing

worldwide, discuss recent developments in developed (OECD) countries
and in the BRICS, and describe transfer pricing / valuation methods
©2011 NERA Economic Consulting www.nera.com

1
Contents
What
Wh t is
i Transfer
T f Pricing?
Pi i ?
The Arm’s
Arm s Length Principle
O
OECD
C Developments
e e op e ts and
a d Recent
ece t Trends
e ds
Transfer Pricing and Valuation Methods
Transfer Pricing Challenges in the BRICS

2
What is Transfer Pricing?

3
What is “Transfer Pricing”?!
Shanghai Daily
Daily, 15 September 2011

4
Case Study 1 - Producing in China
Overview of transfer pricing flows
Transfer Price Market Price
Group Manufacturing Plant Group Commercial entities

China Europe
Related Transaction
Unrelated Transaction

5
Case study 1 - Producing in China
What is the “right” (arm’s length) Transfer Price?
Plant P&L Budget / normal course Following year / sudden drop in

of business demand
Volumes 10000 6000
Transfer Price (per unit) 0.011 0.011 0.013
Revenues 110 66 77
Cost of Goods 35 21 21
OPEX – variable 40 24 24
OPEX - fixed 25 25 25
Operating profit
10 (4) 7
Return on total costs
10% -5.7%
5 7% 10%

6
Case Study 2 - Selling in China
Group Parent (EU)

IP owner / Service Provider
WHAT REMUNERATION FOR PARENT’S IP

AND SERVICES?
Market Price Market Price
Third-party
Third party Group Commercial Entity
Manufacturing Plants China
Asia

7
The Arm’s
Arm s Length Principle

8
The Arm’s Length Principle
What is transfer pricing?

– Transfer
T f pricing
i i refers
f to
t cross-border
b d iintra-group
t t
transactions
ti
- Products
- Services
- Intangibles
- Financial transactions
What does it do for your company?
– It drives the allocation of profit inside your company
- Allocation between business units, divisions, countries…
– And ultimately it is seen as the major controversy issue with the tax authorities

9
The Transfer Pricing Equation
How do you manage it?

– Key concept is “arm’s length”
- Determine the price that would have been agreed between third parties, for
a given transaction
transaction, under similar economic circumstances
IIn order
d tot meett the
th “arm’s
“ ’ length”
l th” requirement,
i t it iis essential
ti l tto adequately
d t l
map the “circumstances”
– To design a transfer pricing system which is consistent with the way
business operates, and follows its dynamics

10
Meeting the Arm’s Length Requirement – Beyond « Compliance »
BUSINESS
OPERATIONS
TRANSFER PRICING
TAX
ECONOMICS
LEGAL
FINANCE

11
Meeting the Arm’s Length Requirement – Sustainable Transfer Pricing System
BUSINESS
OPERATIONS
TRANSFER
PRICING
TAX
ECONOMICS
LEGAL
FINANCE

12
Process For Designing an Arm’s Length Transfer Pricing System
Documentation
« Compliance
C li » Benchmarking
/ Litigation
Industry Functional Economic Implementation / Communication

Sustainable Analysis /
Analysis Analysis / Contracts (internal &
system Value Chain TP design external)
Disciplines ECO BUSINESS ECO / TAX / LEGAL TAX

BUSINESS BUSINESS / IT

13
OECD developments and recent trends

14
The OECD’s Role in the Promotion of the Arm’s Length Principle
Revised
R i d Transfer
T f Pricing
P i i Guidelines
G id li
– Chapters I -III Methods and Comparability (final & approved)
– Chapter IX Business Restructurings (final & approved)
Attribution of Profits to Permanent Establishments (final & approved)

– 2010 version of the Report on the Attribution of Profits to Permanent Establishments
Intellectual Property (on-going)

15
Revised Transfer Pricing Guidelines
Chapter III
C
1 New Guidance on the selection of the “most

1. most appropriate TP method to
R
Revised
the circumstances of the case”

2. New guidance on how to apply the Transactional Net Margin Method
and the Profit Split method in practice
Ch
hapter III
New
3. New Guidance on comparability analysis

Ch
hapter IX
4 Ne
4. New GGuidance
idance on the transfer pricing aspects of b
business
siness
New
restructurings
X
Extract from OECD presentation, Caroline Silberztein, IBC London, March 2011

16
New Guidance on the Transfer Pricing Aspects of Business
Restructurings (Chapter IX)
What is a “business restructuring” in the context of the TP Guidelines?

Cross-border redeployment by a multinational enterprise of functions, assets
and risks; cross-border reallocation of profits (or loss) potential
– Can involve the transfer of valuable intangibles
intangibles, although not always the
case
– Can also,, or alternatively,
y, involve the termination or substantial
renegotiation of existing arrangements.
- example: conversion of “full fledged distributors” into “commissionaires”;
of “full
full fledged manufacturers”
manufacturers into “toll
toll-manufacturers
manufacturers”;; etc
4 Parts:
1 Risks
1. Ri k
2. Compensation of the restructuring itself
3. Remuneration of post-restructuring transactions
4. Recognition of transaction / recharacterisation issues

17
Attribution of Profits to PEs
The Authorized OECD Approach
– The Functionally Separate Entity Approach

- To determine the profits attributable to the PE, a mechanism has to be
developed for attributing risks, economic ownership of assets and capital
to the hypothetically distinct and separate PE, forf associating with the
PE the rights and obligations derived from its “dealings” with other parts
of the enterprise of which the PE is a part and from its transactions with
related
l t d and
d unrelated
l t d parties.
ti
– The Significant People Functions
- The significant people functions relevant to the assumption of risks are
those which require active decision-making with regard to the
acceptance and/or management (subsequent to the transfer) of those
risks
i k

18
Intellectual Property (1/2)
Current guidance: Chapters VI and VIII of the TP Guidelines
Major area of disputes / uncertainty for business and for governments
Main areas covered
– Definition / scope beyond traditional / accounting / legally protectable

i t
intangibles
ibl assets:
t
- e.g. some marketing intangibles, workforce in place, business

opportunities etc:
opportunities,
– Are these intangibles?
– More importantly, should they be compensated at AL?

19
Intellectual Property (2/2)
Main areas identified for possible future work

– R&D; contract R&D
– Know-how, employee assignments (=> Similarities and differences
b t
between th
the characterisation
h t i ti off a service
i or royalty
lt ffor Article
A ti l 12 purposes
and the TP notion?)
– Marketing intangibles
– Business attributes and others
– Identifying and characterizing an intangible transfer
– Right of an enterprise to share in the return of an intangible it does not
own:
- Notions of “economic”, “beneficial”, “functional” ownership?
– Cost contribution arrangements
g
– Valuation of intangibles

20
Transfer Pricing and Valuation
Methods

21
Transfer Pricing Methods for Pricing Transactions
Comparable Uncontrolled Resale Price Method Cost Plus Method Transactional Net
Profit Split
Price Method (CUP) (RPM) (CPLM) Margin Method (TNMM)
• Comparable intra-group • Compares the intra- • Compares the • Splits the profits • Compares the
price to prices earned in group resale margin markup on costs of between the related controlled company's
comparable uncontrolled (gross margin) to the tested party to companies profitability to the
OVERV
transactions under resale margin earned the markups earned engaged in the one of similar
comparable in comparable in comparable same transaction(s) companies
circumstances uncontrolled uncontrolled based on the
VIEW
transactions under transactions under related value of

• Internal/External CUPs
comparable comparable each company's
circumstances circumstances contribution to the
combined profit
• "The most direct and • Less comparability • Less comparability • Adapted when both • Simple
reliable way" to apply the required than in the required than in the parties in the • In practice, the most
arm's length principle CUP method CUP method related-party
used
transaction have
• Well adapted to • Well adapted to • Less comparability
PR
developed
distribution activities manufacturing
ROS
significant
i ifi req ired than in
required
activities and CUP, RPM and
intangible assets
provision of services CPLM
• High comparability • Financial data (gross • Financial data (gross • Complex

C l economic i • Ex-post / testing
required (products, profit) of comparable profit) of comparable analysis method
volumes, markets) companies may not be companies may not • Not adapted to all • Net margin may be
• Lack of publicly available available be available economic models impacted by non-
CO
data • Consistency
Co s s e cy o
of • Consistency
Co s s e cy o
of transfer
a se p pricing
c g
ONS
accounting standards accounting issues

standards

22
Valuation Methods for Pricing Assets, Rights, Businesses or Companies
Cost approach Market approach Income approach

• Seems easy to implement • Direct measure of the value of a • Most accurate measure of
company based on references asset/company value, as equal
to multiples derived from to the net present value of
publicly-traded comparable expected future cash flows of
Strengths
g companies and/or transactions the asset/company
• Take into account the
specificity of an (intangible)
asset/company
More complex
M • l ththan it seems • R
Reasonable
bl llevell off • R b t
Robustness off projections
j ti
• Replacement costs should comparability with the publicly-
be computed not actual costs traded/acquired companies is
Weaknesses • Provides a wrong measure, necessary
in general the lower end off
the range
• The method is rarely used for • The method is frequently used • The income approach provides
Our point of asset/company valuation, for company valuation given the most accurate asset /
view except in cases where it is the availability of publicly- company value
assumed that no value above traded/acquired companies
the costs incurred is • For asset valuation, multiples
perceived to have been may not be readily available
created

23
The Economic Framework for Accurately Valuing IP
Most firms originate their value and growth through a combination of unique
know-how, intangibles, and value-creating activities
Intellectual Property (IP) can generally be considered as key differentiators for
the group and ultimately at the origin of a performance above average
Accurate valuations can only be developed under the economic framework that
reflects:
– The competitive advantage to the user of the IP and
– The opportunity cost to the owner of the IP
The economic framework is superior to other valuation methods

– Adapts to the specific context of the IP
– Is best suited to deal with the uncertainty associated with IP

24
Transfer Pricing Challenges in the
BRICS

25
BRICS and FDIs
Expected location of FDI by MNEs in 2011-2012

Number of responses
120
100
80
60
40
20
y
na
am
l
o
S
K
zi
an
si
di
si
ic
U
U
ra
hi
ne
us
In
ex
tn
m
C
ie
do
R
er
M
G
In
Source: World investment prospects survey 2010-2012
2010 2012 – United Nations

26
The BRICS’s Economic Environment
2000 - 2010 2010 - 2020
Produce in China (or

Produce in China, Sell outside),
), Sell in China
outside
t id China
Chi
Location savings at stake L

Location
ti savings
i att stake
t k
and… « market premium »

27
Examples of Subjects at a Center Stage in China
“substantial market premium in the

auto
t iindustry”
d t ” (SAT, July 2010)
“location
location savings, intangibles,
and market premiums” (SAT, April 2010)
“unique potential in the Chinese

market
market” (Director Wang, head of APA program July 2009)
“how
how cost advantage impacts profitability
profitability”
(Director Wang, head of APA program July 2009)
“RMB0
RMB0.5
5 billion was collected as additional tax revenue in
BAPA cases in 2009 applying the concepts of location saving
and market intangible”
intangible (SAT)
28

Transfer Pricing

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Economic Consulting

Introduction to Transfer Pricing Principles,

Hong-Kong, The Hong Kong Bankers Club, 28th September 2011

 Provide an overview of the principles governing transfer pricing

©2011 NERA Economic Consulting  www.nera.com